Investopedia/Damian Davila: Using Collateral to Obtain a Loan for Your Small Business

Using Collateral to Obtain a Loan for Your Small Business By Damian Davila | December 16, 2015 — 12:56 PM EST


When small businesses have lags between cash coming in and cash going out, they can use collateral to obtain the necessary funds for short-term needs, such as paying employees and purchasing raw materials. Issuers of asset-based lending accept only certain types of assets as collateral and have special requirements. Review qualifying assets that can be used as collateral and best practices when looking for asset-based loans.
Qualifying Assets for Collateral in Asset-Based Loans

Lenders accept accounts receivable; high-quality balance sheet items such as manufacturing equipment and trucks; and product inventory as collateral for asset-based loans. Each type of asset provides a different set of advantages and disadvantages to the borrower.
Accounts Receivable

Owners of small businesses can only use their highest quality accounts receivable, often those under 60 to 90 days, as collateral for asset-based loans. Lenders value accounts receivable with 20 to 30% discounts off the actual value. In case a borrower defaults on his asset-based loan, the lower valuation allows the lender to settle the receivables at a discount, encouraging faster payment, and still make a profit.

A disadvantage of using some of your most liquid assets as collateral is you could end up in a bigger cash crunch if those assets are seized by your lender. Another disadvantage is the bank can ask for updated financial statements, including projections for upcoming quarters or fiscal years, to reach a final decision.
Manufacturing Equipment and Trucks

Unlike accounts receivable, manufacturing equipment and industrial vehicles are valued at less than 70% of their actual values. Lenders have to account for additional costs and challenges. When there is a very limited pool of potential buyers for a specific machine or vehicle, the financial institution issuing the loan may have diminished bargaining power. The lender may require additional appraisals to have a better idea of the true market value of the asset and include the cost of those appraisals in the fee schedule of the loan. In the event a liquidation of the asset does not cover the entire balance of the loan, the business owner is still liable for the remaining debt.
Inventory

Whether they are made of raw materials or finished goods, inventories have the lowest valuation out of the possible assets that can be used as collateral for a loan. Depending on their size, inventories may require storage space, climate control and security. Lenders appraise eligible inventories at about half of their market values. When using inventory or other operating assets as collateral, a business owner often has to insure and appraise the assets. To reduce its exposure to risk, a lender may have additional requirements for issuing an asset-based loan.
Best Practices When Looking for Asset-Based Loans

Small businesses that are just starting out or have limited business credit histories can use asset-based lending as a solution to fund their short-term cash needs. No matter which of the three types of collateral a business owner plans to use, he needs to have his financial statements in order and up to date.

By anticipating all of a lender's potential requirements, such as appraisals, insurance policies and settlement history of receivables, a business owner increases his chances of securing an asset-based loan. Consider all of your available financing options before signing up for asset-based lending. In 2012, only one in every three small business owners knew his actual business credit score, according to a March survey of 889 small firms by The Wall Street Journal and Vistage International, a San Diego-based executive-mentoring group. A secured loan is preferable to an unsecured loan and allows business owners to strengthen their business credit scores.
The Bottom Line

Getting short-term financing is possible with the right collateral. Take notice of the requirements for each type of collateral and prepare accordingly. While asset-based lending has some intrinsic risks, it can provide much needed capital to get out of a cash crunch and increase company revenue.
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